Bond markets expect a surge in inflation underscored by U.S. retail prices data on Wednesday to abate even if price pressures worsen in the very near term, though investor opinions should vacillate amid divisions about how soon the Federal Reserve will act to choke off rising prices.
Data on Wednesday showed that the U.S. Consumer Price Index increased more than expected in October as the cost of gasoline and food surged, leading to the biggest annual gain since 1990, further signs that inflation could remain uncomfortably high well into next year amid snarled global supply chains.
Even as nerves grow over an acceleration in price pressures near-term, however, longer-dated measures show that they are unlikely to last.
“The signals that we’re getting from the breakeven market is that all’s well, at least on longer run inflation trends,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale in New York.
The Treasury breakeven inflation curve, a measure of what inflation level a investor would break even on a given Treasury note yield, shows that investors expect inflation to run at 4.80% in the coming year, before declining to 3.65% in two years, 3.16% in five-years and 2.68% in 10-years.
The Fed’s favorite indicator, the five-year forward inflation rate, which measures where annual inflation is expected to be in five years, was last at 2.30%. It is below the 2.41% level reached on Oct. 15, which was the highest since 2014.
“It hasn’t really broken through even 2.50%, so to me that should make the Fed feel comfortable that the market’s not pricing in, or at least not expecting runaway inflation,” said Rajappa.
The Fed is targeting an average annual inflation of 2% but has said that it would allow inflation to run hotter than usual to make up for previous underperformance.
Fed officials including Chair Jerome Powell have maintained that the inflation surge is “transitory,” and Powell said last week that he expects it will moderate next year.
Some investors are not as confident though.
Two-year yields have surged and the yield curve has flattened as investors adjust to the prospect of tighter monetary policy while fed funds futures are showing that investors expect the U.S. central bank could raise rates as soon as July 2022.
“The most meaningful trend I think is the flattening of the curve, as the market is kind of assuming a more aggressive normalization path from the Fed,” said Ben Jeffery, an interest rate strategist at BMO Capital Markets in New York.
Brian Reynolds, chief market strategist at Reynolds Strategy, said that some difference between investor outlooks can be explained by how they define “transitory,” noting that some equity investors have interpreted the word to mean months, while fixed-income investors see it as years.
“There’s a camp of equity investors who are convinced it’s going to be permanent, and they seem to be playing in the interest rate space, forcing short term rates up in anticipation of the Fed following suit because of inflation,” Reynolds said.
However, “consistently this year the fixed income market has priced in two years of rising inflation and then inflation coming back down after that. In the last couple of months, they’ve priced in a little bit more inflation in the next two years, and a bigger slowdown in inflation in the ensuing year,” Reynolds added.
That means the takeaway for now is that “the debate over inflation has become a little more volatile,” Reynolds said.
Analysts at TD Securities, meanwhile, said this week that they expect inflation to “slow significantly” in 2022 as fiscal stimulus fades and supply constraints ease, even though price pressures may continue to climb in the very near term.
The bank expects annual CPI increases to drop to 2.1% by December 2022, and core CPI to drop to 2.3% in the same time frame. That compares with 6.2% and 4.6% last month.
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